Why Are Lawyers Gunning for Fifth Street Finance Corp.?

Investors have probably noticed that securities lawyers are now targeting Fifth Street Finance because of its poor stock performance in recent months. I'm not a lawyer, so I won't comment on whether or not these suits have any traction.

However, having read the 53-page complaint, I will say that there are some noteworthy allegations being made against Fifth Street Finance and its manager, Fifth Street Finance Asset Management . This is a great opportunity for investors to learn about some of the dangers of business development companies and the difficulties of analyzing them.

What's the beef?The complaint asserts that Fifth Street Finance inflated its performance around the time it took its external manager, Fifth Street Asset Management, public.

The main subjects are three Fifth Street portfolio investments -- JTC Education, Phoenix Brands, and TransTrade Operators -- which, shareholders might remember, were all placed on non-accrual in the fourth calendar quarter of 2014. (A non-accrual loan is one on which a lender has decided to no longer recognize income.)The fourth calendar quarter of 2014 was suspiciously the first quarter after Fifth Street Finance Asset Management went public.

The premise of the complaint is that these companies should have been placed on non-accrual earlier. But because Fifth Street Asset Management was slated to go public, troubled investments were allegedly hidden to make its portfolio look better than it was. In addition, keeping investments on accrual would result in higher revenue and earnings for FSAM, leading to a higher valuation at IPO.

For brevity's sake, I'll discuss only one of these portfolio companies in depth. We'll look at TransTrade Operators, which has an interesting history on Fifth Street Finance's books.

The TransTrade storyTransTrade had been in trouble for quite some time. On March 31, 2014, Fifth Street valued its investments in the company at roughly 58% of cost.

While definitions vary, it's generally accepted that a debt security that trades at a 20% discount to par value is, by loose definition, considered "distressed."Valued at a 21% discount to principal and cost in March 2014, TransTrade's first lien term loan fits this definition. We'll start off there.

Here's how Fifth Street Finance valued its investment in TransTrade as of March 2014:

Source: Page 5 of Fifth Street Financial's 10-Q.

The first lien term loan is valued at about 79% of cost. The preferred and common units are marked to zero; they're worthless as of March 2014.

This is our starting point. Over the next few quarters you'll see how Fifth Street kept this company on life support with additional capital infusions.

Summertime woesLet's move to the next quarter, which ended June 2014. Fifth Street reported that it owned a new security in TransTrade's capital structure, showing that it invested $1.4 million into Series A preferred units, which were immediately written down to zero within the quarter. Notice that the Series A preferred units did not exist in the prior quarter.

Source: Page 5 ofFifth Street Financial's 10-Q.

Also note the slight increase in the cost of its first lien term loan (from $14.7 million to $15.2 million), which will occur in every quarter in excess of the 3% (annual) paid-in-kind rate.

Interest income, though accrued as income in Fifth Street Finance's results, apparently isn't being paid in cash. It appears the bulk of the interest due is accruing to the principal value of the first lien term loan. That's not good.

Yet despite an intraquarter writedown on a new investment in the preferred equity, and the accrual of interest as principal, TransTrade remained on accrual status. Most egregiously, TransTrade was given a risk rating of 1 or 2, which means that it was "performing substantially within [Fifth Street Finance's] expectations" or better.

More money in autumnFifth Street invested more in TransTrade in the next quarter, presumably so it could keep it on accrual and continue to recognize interest income. The BDC invested another $600,000 in TransTrade's preferred equity, and once again, the investment was immediately marked to zero intraquarter. The principal balance of the first lien term loan jumps again to roughly $15.6 million from $15.2 million.

Source: Page 89 ofFifth Street Financial's 10-K.

If it weren't clear in March, when TransTrade was valued at 58% of cost, it's quite clear that this isn't a healthy company, now valued at 49% of cost even after new capital infusions. Yet Fifth Street is recognizing income from this investment as if everything is OK.

FSAM goes public and Fifth Street Finance comes cleanFifth Street Asset Management priced its IPO on Oct. 29, 2014, after a rocky IPO process. Its first trading day was Oct. 30.

Finally, in December 2014, TransTrade was put on non-accrual. Fifth Street again doubled down with another $2 million investment in the preferred units, while TransTrade drew down on its revolver. Both investments were immediately impaired, consistent with history. It seems very little has changed.

Source: Page 5 ofFifth Street Financial's 10-Q.

At this point, Fifth Street had come clean, placing TransTrade and other investments on non-accrual. Fifth Street's earnings report, and its sudden non-accrual problem, shocked the market. Shares dropped quickly, losing 15% over the full trading day. The timing was impeccable; just imagine if this non-accrual had appeared when its execs were on a road show to pitch shares of the asset management business!

No one-size-fits-all ratioI don't want to rub salt in the wound. Shareholders have experienced enough pain over the last few months. But this serves as an important reminder that a BDC's non-accrual ratio (the percentage of assets for which it isn't recognizing interest or dividend income) is not a perfect metric for understanding credit quality. For months, TransTrade and other investments avoided the non-accrual list despite the fact that they were very stressed and arguably deserved the non-accrual label.

When a BDC wants to move the goal posts by deferring non-accruals, it's quite easy to do. All it takes is a little imagination and a little more capital. If you continuously feed capital to underperformers, then you can forever ensure that an investment will never go bad.

I have no insight into what will come of the suits filed against Fifth Street; perhaps nothing will come of them at all. But I think BDC investors could learn a lot by reading the legal complaint. This isn't the first time a BDC has dressed up its portfolio, nor will it be the last.

The article Why Are Lawyers Gunning for Fifth Street Finance Corp.? originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.